A New York sales tax audit can be a grueling experience. The rules are complex, and it often comes down to the records, which are usually voluminous. A sales tax audit is typically a paper audit; the taxpayer must provide adequate documentation to support reportable sales and purchases for the period under examination. This is partly because sales taxes are trust taxes, and vendors are charged, as trustees of the state, with collecting and remitting the proper amount.
What happens when a business has bad records? Is the audit over before it’s begun? Are penalties assured? CPAs advising or representing companies should be reminded that taxpayers have certain defenses to an assessment, even when the books and records are lacking. This article will provide CPAs with some of the basics and highlight a recent—and rare—taxpayer victory before the New York State Division of Tax Appeals.
Which Records to Keep
Businesses are required to keep all records and documentation necessary to enable an auditor to independently verify the information reported on a sales tax return [Recordkeeping Requirements for Sales Tax Vendors, TB-ST-770 (6/2/2011)]. This includes total sales, taxable sales, taxable purchases, tax collected, credits, and tax due.
For sales transactions, businesses should keep records of every sale, the amount of each sale, the sales tax charged, the sales tax collected, and documentation supporting applicable exemptions. Each sales slip, invoice, receipt, guest check, and cash register tape, among other records, must be kept in an organized fashion.
For purchase transactions, records must be maintained to establish the taxable status of all purchases of property or services. Purchase records must substantiate whether sales tax was paid on those purchases or whether use taxes are due.
There are special rules for point-of-sale (POS) systems, but generally speaking, electronic records must be maintained and readily accessible in the same fashion as paper records. Under New York law, records should be kept for a minimum of three years.
Consequences of Improper Recordkeeping
During a sales tax audit, a taxpayer has the right to have its books and records examined as the basis of the auditor’s review, as opposed to some other audit method. When a business does not have proper and sufficient records, however, the law allows the auditor to utilize various indirect methods to project the tax due from whatever information is available to construct an estimated bill assessing tax plus penalties and interest.
For example, an auditor can conduct an observation test and count the number of customers for a given period—such as a Friday night for a restaurant—and project those sales across the entire audit period—even though business is likely much slower on Monday and Tuesday nights. The auditor could also examine rent or utility expenses and project what sales might have been, based upon certain industry averages and ratios. A retail business’s rent may be high and sales may be slow, but without accurate records of its actual activities, the auditor is generally allowed to make these types of statistical projections. After all, the taxpayer was supposed to track and maintain its own records.
Indirec Audit Methods Must Be Reasonable
Once a taxpayer is determined to have inadequate records, auditors are granted considerable latitude in selecting an indirect audit methodology. The auditor’s methodology must be reasonably calculated to reflect the tax due, but the courts have been clear that exactness is not required.
Nevertheless, auditors are not entitled to select just any indirect method. Rather, the auditor’s method must be “reasonable,” and the resulting assessment cannot be “erroneous.” Taxpayers bear the burden of proving by clear and convincing evidence that the audit methodology is flawed. This is can be a high bar, but under the right circumstances, taxpayers have mounted successful challenges asserting these grounds.
Recent Taxpayer Victory
On November 15, 2018, Majestic Deli Grocery, Inc., a deli and grocery store operating in Harlem, New York, prevailed on these issues before New York’s Division of Tax Appeals [In re Majestic Deli Grocery, Inc., DTA Nos. 827533 and 827534 (N.Y. Division of Tax Appeals, ALJ Unit)]. The taxpayer in this case had poor records, but it won at trial, and the auditor’s assessments were canceled.
By all accounts, the audit was routine; requests for records were made, but information was lacking. Cash register tapes were not itemized and incomplete. Purchase records were incomplete. No general ledger, purchase journal, or cash disbursements journal was provided. Bank deposits could not be reconciled to gross sales reported on the taxpayer’s sales tax returns. Needless to say, the taxpayer’s books and records were inadequate.
Unable to review the taxpayer’s actual records, the auditor ultimately decided to estimate sales utilizing the business’s rent expense, obtained from its federal income tax returns, multiplied by certain IRS industry ratios. In other cases, courts have approved this type of indirect methodology. In fact, the judge in this case explicitly agreed that, under the circumstances, the use of this method was generally proper in the Majestic audit.
The auditor, however, went too far. This was a deli/grocery, and it sold a mix of taxable and nontaxable items. Sales of milk, juice, fruit, and yogurt, for example, are exempt from tax. The auditor’s method, however, did not allow for any nontaxable sales, despite acknowledging at trial that he was aware of them. Furthermore, the auditor argued that he had, in fact, accounted for such nontaxable sales by allowing 100% of food stamp sales as nontaxable sales. He even went so far as to argue that a tax assessment is presumed to be correct and that without proper documentation, the taxpayer could not rebut that presumption.
The taxpayer, in response, argued that the auditor’s methodology was fundamentally flawed, and the administrative law judge agreed. While the taxpayer’s records were incomplete, the judge concluded that it was not reasonable to simply ignore the nontaxable sales. Consequently, he canceled the sales tax assessments against the store and its owner.
The takeaway from this case, and others like it [In re 3152 Restaurant, Inc., DTA Nos. 827174, 827175, 827176, and 827177 (N.Y. Division of Tax Appeals, ALJ Unit) (12/28/2017); In re 33 Virginia Place, Inc., DTA No. 821181 (N.Y. Tax Appeals Tribunal) (12/23/2009)], is that auditors sometimes overreach. A careful understanding of the auditor’s methodology can expose errors and issues that undermine the assessment, regardless of poor recordkeeping by the taxpayer. Good recordkeeping practices are essential to running a healthy and profitable business, but even businesses with bad recordkeeping practices have rights and defenses that can be used to protect against overzealous—if well-intentioned—auditors.